Mezzanine Financing 101: An Overview

In the post-recession world, it can be difficult to find the financing you need for your commercial real estate projects. Lenders are hesitant to take risks, and using other forms of financing such as friends or business partners/investors can still leave you short of the money you need to see your venture through. Mezzanine financing fills in this gap between personal equity loans and outside sources of funding. The following will give you a basic understanding of what a mezzanine loan is and the different forms it can take.

What is a Mezzanine Financing?

Mezzanine financing is a broad term used for any means of financing that fills the gap between sponsor equity and senior debt. While this can take the form of either equity or debt, it is generally issued by members of the private sector.

Mezzanine financiers typically do not receive a return on their investment until all senior debt holders are compensated. While this position does cause mezzanine loans to have a higher risk factor, they still enjoy a lower risk than preferred equity.

Basic Mezzanine Loan Structures

When a mezzanine deal is structured as debt, it will require one of several forms of collateral: second deed of trust, assignment of partnership interest or a cash flow note. A second deed of trust is the preferred form of collateral for most mezzanine lenders, because it gives them the most concrete form of security. However, the assignment of partnership interest is the most widely used form of debt security. The mezzanine lender essentially becomes the owner of the equity and takes on the obligation to the first mortgage lender. A cash flow note, also called a soft second, gives the lender an assignment of the cash flow from the property in return for the mezzanine loan and a percentage of the revenue from the sale of the property.

Mezzanine loan deals that are structured as equity are joint agreements between the equity owner and the mezzanine lender. These arrangements are guided by partnership agreements and with provisions regarding who has the authority to make decisions and which decisions must be approved by the mezzanine partner. The risk involved in this kind of lending structure is that the owner has less control, and if the property doesn’t perform as expected, the owner may lose control completely.

Mezzanine financing may seem a little risky, since you lose some flexibility, control and will in the long run pay more for the initial capital. Nevertheless, it is a popular option, as it also allows you to pay less cash initially while gaining an important business partner that may provide much-needed support if the project starts to waver.